Property Transactions – Business Assets
Introduction & Review of Asset Categorization
In prior chapters, we learned about the general rules governing the taxation of
property transactions, and how the sale of capital assets is treated in the income tax
system. In that discussion, we learned that there are three types of assets in our tax
system – ordinary income assets, capital assets, and Sec. 1231 assets. The prior chapter
dealt with capital assets, which is the catch-all asset category. For income tax purposes,
everything in the world is a capital asset except specified items, which are detailed in
I.R.C. Sec. 1221. For financial planning purposes, remember that everything in the world
is a capital asset except ACID (Accounts Receivable, copyrights, inventory, and
depreciable real or personal property used in a trade or business). This chapter deals with
the taxation of the other two asset categories for income tax purposes – ordinary income
assets and Section 1231 assets.
Ordinary Income Assets
Ordinary income assets generate gains that will be taxed at ordinary income tax
rates. If an individual engages in business by selling goods or services, for example, the
income generated from that business will be taxed at ordinary income tax rates.
Out of the items that are not defined as capital assets under I.R.C. Sec. 1221
(Accounts Receivable, Copyrights, Inventory, and Depreciable Real or Personal property
used in a trade or business), the first three items are ordinary income assets. These items
simply represent future or earned ordinary income, so the code will not allow taxpayers
to change the characterization of that income simply by changing the nature of the asset.
You may recall that Accounts and Notes receivable, the first type of ordinary
income asset, is really just deferred ordinary income. The sale of a good or service in the
ordinary course of business generates ordinary income. Transforming that transaction
from cash to an account or note receivable does not change the ordinary income nature of
the transaction.
Inventory is held for resale to customers in the normal course of business, and
therefore generates ordinary income upon sale. Consequently, any inventory held by a
business is considered an ordinary income asset. Copyrights, musical compositions, and
artistic creations in the hands of the author are ordinary income assets because they are a
form of inventory. An artist creates a masterwork with the intent of selling it, and is
therefore creating inventory for his business, which is the creation and sale of pieces of
art. Recall from our discussion in earlier chapters, however, that copyrights, musical
Page 1 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
compositions, and artistic creations in the hands of someone other than the creator may
not be considered ordinary income assets.
When a taxpayer generates ordinary income, it is taxed at ordinary income tax
rates, which, under current law, are the highest tax rates in our income tax system. If a
loss is incurred when engaged in business, the loss may be deducted and is not subject to
limitations. In some cases, the loss may even be carried back to prior tax years to
generate an income tax refund for those years! While generating losses is not the
objective of a well-run business, if a loss occurs, a taxpayer would prefer to have that loss
be treated as an ordinary loss so that he or she can make full, current use of that loss to
offset other income. In the realm of ordinary income assets, speaking strictly from an
income tax perspective, losses are good and gains are bad. Losses are unlimited, but
gains are subject to tax at the highest rate.
Section 1231 Assets
Since the first three exceptions to the definition of a capital asset are defined as
ordinary income assets, the only asset that is left, depreciable real or personal property
used in a trade or business, is a Section 1231 asset. One additional requirement is
necessary for an asset to be classified as a Section 1231 asset. In addition to being
depreciable real or personal property used in a trade or business, the owner of the asset
must have a long-term holding period (the owner must have held the asset for more than
1 year) for the asset.
The definition of Section 1231 asset, “depreciable real or personal property used
in a trade or business,” is redundant. From our discussion of basis rules, we know that
any asset used in a trade or business that will decline in value qualifies for depreciation
deductions. Another way of looking at this is that for depreciation to apply, the asset
must be a trade or business asset. Personal assets cannot be depreciated. Trade or
business assets subject to depreciation are Sec. 1231 assets.
Benefits of Sec. 1231
The significance of Section 1231 is that once an asset is categorized as a Section
1231 asset, gains generated from the sale of the asset are treated as capital gains for
income tax purposes, and losses generated from the sale of the asset are treated as
ordinary losses for income tax purposes. Therefore, gains will qualify for the favorable
long-term capital gains tax rate, and losses will not be subject to the limitations that
typically apply to capital assets.
Gains on Section 1231 assets will qualify for the long-term capital gains tax rate
because the owner of the asset held the asset for more than 1-year (a long-term holding
period is required for an asset to be categorized as a Sec. 1231 asset). Losses, however,
Page 2 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
will be treated as ordinary losses, and will therefore not be subject to the limitations that
apply to capital losses.
Section 1231 gives the taxpayer the best of both worlds treatment. As noted in
our prior discussions, given a choice, taxpayers would characterize all of their losses as
ordinary losses (because no limitation applies and the higher ordinary tax rate generates a
greater tax benefit from the loss), and all of their gains as capital gains (to take advantage
of the lower capital gains tax rates). Section 1231 gives the appearance of tax nirvana,
but further considerations, discussed below, will explain why Congress has given
taxpayers what appears to be the best of both worlds tax treatment.
The tax treatment also differs depending on whether an individual or a Ccorporation generates the Section 1231 gain or loss.
If an individual generates a Section 1231 gain, the favorable, lower capital gains
rate (currently 15%) will apply. If the taxpayer is in the 15% ordinary income tax bracket
or lower, the 5% capital gains tax rate will apply. Conversely, if a loss is generated, the
taxpayer can write off that loss, without limitation, against other forms of income for the
current, and possibly, past years (due to the imposition of the look-back provision). Had
the loss been categorized as a capital loss, the $3,000 loss limitation rule would apply,
and the loss may not be fully utilized by the taxpayer in the current tax year.
C-corporations do not qualify for the lower, favorable tax rate on capital gains.
Therefore, the generation of a Sec. 1231 gain will not result in a tax benefit for the
corporation, since it pays the same tax rates on its ordinary income and capital gains. If a
corporation generates a Section 1231 loss, however, the loss will be considered an
ordinary loss, and may be deducted in full against other income (or carried back if the
carry-back rule is invoked). For corporations, capital losses may not be deducted against
other forms of income – capital losses can only be used to offset capital gains.
Categorizing an asset as a Section 1231 asset, therefore, allows the corporation to
recognize losses without having to generate capital gains to offset them.
Entities that are taxed as pass-through vehicles, such as partnerships, limited
liability companies, limited liability partnerships, and S-Corporations “pass-through”
their tax results to their owners, so the individual, not the corporate rules, apply. Owners
of these entities qualify for the special 15% capital gains tax rate on their Section 1231
gains.
The catch – Depreciation Recapture
Section 1231 looks almost too good to be true, and it would be if the analysis
ended at asset categorization. Once the taxpayer has categorized the asset as a Section
1231 asset, however, an additional consideration must be addressed – depreciation
recapture.
Page 3 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
In order to be classified as a Section 1231 Asset, the asset must be “depreciable
real or personal property used in a trade or business.” When an asset is sold that was
subject to depreciation, depreciation recapture may apply. In order to understand
depreciation recapture, it is first necessary to review the purposes and uses of
depreciation.
The purpose of depreciation is to allow individuals and businesses who use
property in productive use or in a trade or business to recoup their capital over the useful
life of the asset so that capital can be reinvested to generate more income.
In an ideal world, the depreciation deduction that would be claimed by the
taxpayer each year would be the actual decline in value of the asset, representing the
portion of the asset that was used up in that tax year. Doing this, however, would be
impractical – it would require every asset to be appraised every year, followed by a
comparison of the end of year value to the beginning of year value simply to ascertain the
current year depreciation deduction.
Recognizing that it would be unreasonable to require taxpayers to do this for each
asset they own to justify their depreciation deductions, Congress came up with a statutory
scheme for depreciation. In this statutory scheme, upon acquisition, each asset is pigeonholed into a specific class life based on the general rules set forth in the code. The class
lives of various types of assets were discussed in a prior chapter. Once the class life is
determined, a statutorily defined deduction is taken for depreciation of the asset,
regardless of the actual decline in value of the asset from year to year. Since the
depreciation deduction is not based on the actual decline in the value of the asset, it could
be thought of as a “make-believe value”, based on averages calculated by the IRS. This
“real world” approach that generates a “make-believe” depreciation value is convenient
and relatively easy to apply, but generates tax results that do not directly correspond to
the ideal world, where depreciation deductions would be based on the actual decline in
the value of an asset each year.
Many assets that are purchased for use in a trade or business are completely used
up in that trade or business, and are disposed of when their useful life expires. Often,
upon disposal, the taxpayer receives nothing in return for the asset. When this happens,
the taxpayer has recouped his or her capital investment in that asset over the useful life of
that asset, and there is nothing to be concerned about for income tax purposes.
EXAMPLE: Randy, a highly sought after financial planner in his community,
opened a new office several years ago. He purchased computers for use by his
staff, and the computers were classified as 5-year class life property. Over the
next 6 years, Randy and his staff used the computers, at which time they were
replaced with new machines. The old machines were disposed of. Randy was
able to recover his capital investment in the computers over the 5-year class life
Page 4 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
through depreciation deductions, and he received nothing upon disposition of the
computers. Consequently, the disposal of the computers does not trigger any
income tax consequences.
When an asset is sold, a realization event occurs for income tax purposes and gain
or loss must be calculated. When the asset sold is a Section 1231 asset, the taxpayer may
breathe a sigh of relief, since he or she knows that the best of both worlds tax treatment
will be afforded. Before that can happen, however, depreciation recapture must be taken
into consideration. Section 1231 treatment only applies to the economic (i.e., ideal world
) results of the transaction. To get to the economic result to which we apply Section
1231, we must first make sure that the depreciation deduction taken in the real world (by
using the “make-believe” value based on the class life of the asset) equals the
depreciation deduction that would have been taken in the ideal world (where the
deduction equals the actual decline in value each year).
From a planning standpoint, whenever you identify an asset as a Section 1231
asset, and that asset is sold, you must first consider the possibility of depreciation
recapture before the “best of both worlds” approach can apply. The ONLY time that
depreciation recapture is an issue is when the asset has been categorized as a Section
1231 asset. If the asset is a capital asset, or an ordinary income asset, depreciation
recapture does not apply.
Depreciation Recapture
The sole purpose of depreciation recapture is to ensure that, when an asset is sold,
the taxpayer receives back his or her capital tax free – no more, and no less. The rules
for depreciation recapture differ depending upon the type of property sold in the
exchange.
Recapturing Depreciation on Personal Property
If personal property used in a trade or business is sold, I.R.C. Sec. 1245 sets forth
the rules for deprecation recapture.
Personal property, as used in Sec. 1245, means anything that is not real property.
The depreciation recapture provisions of the Code (Secs. 1245 and 1250) use the legal
definition of property. Real property is land and anything permanently attached to the
land (such as buildings, trees, and swimming pools). Personal property is everything
else in the world (i.e., anything other than land or things permanently attached to the
land). Used in this context, personal property does not imply that the property is used for
personal, as opposed to business purposes. As described in the triads of income Taxation
(Chapter ____ ) , both real and personal property can be used in one of three ways for
income tax purposes: 1. personal use (for example, your personal residence and
furnishings); 2. production of income use (for example, the residential rental building
Page 5 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
and furnishings that you own); or 3. trade or business use (for example, the office
building and furniture used in your trade or business).
When personal property is used in a trade or business or for the production of
income, it is depreciable, and therefore becomes a Sec. 1231 asset. When that property is
sold, Section 1245 governs the depreciation recapture rules. Simply put, Section 1245
states that when personal Section 1231 property is sold, depreciation is recaptured as
ordinary income to the extent of the gain. This means that before capital gains treatment
can result under Sec. 1231, all of the depreciation must be paid back. Since depreciation
was taken as a deduction against ordinary income, when depreciation is recaptured, it will
be treated as an addition to ordinary income.
There are only four potential results under Sec. 1245. While the numbers in each
example or problem will change, if you can identify which of the four scenarios applies,
you will be able to quickly ascertain the tax consequences. The best way to describe the
application and purpose of Section 1245 is by example. The examples of the application
of Sec. 1245 will be based on the following base facts:
FACTS: Kasey, a high school student, decided to apply some of the principles of
entrepreneurship that have been taught to him by his uncle, and opened the KB
Lawnmowing Service, LLC. Kasey purchased several pieces of equipment, and
hired his high school friends to help him provide lawnmowing services. One of
the items Kasey purchased when he opened the business two years ago was a
riding mower. He paid $1500 for the mower, and has since taken $400 in
depreciation deductions. Due to the popularity of the company’s service, Kasey
now needs a heavy-duty mower, and has decided to sell his existing riding mower
to purchase the heavy-duty equipment. Kasey would like to know what the tax
consequences of such an action would be, and has asked you, his financial
advisor, for advice.
As Kasey’s financial advisor, the first thing you will do when faced with a
property transaction question is ascertain what type of asset you are dealing with. In this
case, Kasey purchased a lawnmower for use in his trade or business, and has been taking
depreciation deductions on that asset. Consequently, the asset is a Section 1231 asset.
Once the asset has been classified as a Section 1231 asset, you know that gains will be
taxed as capital gains, and losses will be taxed as ordinary losses, provided that the
depreciation recapture rules have been satisfied first. The asset Kasey proposes to sell is
a lawnmower, which is a personal asset (it is not land or anything permanently attached
to the land), so the depreciation recapture rule that applies will be found in Sec. 1245.
Section 1245 tells us that we recapture deprecation to the extent of the gain when a
personal asset used in a trade or business is sold.
EXAMPLE 1: What is the tax result if Kasey sells the riding lawnmower for
$1,100?
Page 6 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
Since we have already classified the asset and identified the depreciation
recapture rule that will apply, we must calculate gain or loss in order to answer
this question. In this example, the amount realized will be $1,100. To calculate
gain or loss, we must subtract Kasey’s adjusted basis in the asset from the amount
realized in the transaction.
Kasey’s adjusted basis is his cost basis of $1,500 reduced by his cost recovery
deductions (or return of capital from depreciation) of $400. Kasey’s adjusted
basis, therefore, is $1,100.
Using the formula for calculating gain or loss found in I.R.C. Sec. 1001, we find
the following:
Amount Realized (AR)
Adjusted Basis (AB)
Gain/(Loss)
$1,100
$1,100
-------0
Since there is no gain or loss, there is no depreciation recapture, and no tax
consequence.
For obvious reasons, out of the four possible outcomes for the sale of personal
Sec. 1231 property, this is the simplest result – there are no tax consequences. This result
will rarely occur in real life, but it does illustrate an important point. This example shows
what happens when the “ideal world” and the “real world” meet. Despite the fact that the
depreciation deductions taken by Kasey were formula amounts based on averages set
forth in the Internal Revenue Code, the actual depreciation in the asset equaled the
amount of depreciation claimed for income tax purposes. Kasey purchased the asset for
$1,500. He received his entire investment back through depreciation deductions ($400)
and proceeds from the sale of the asset ($1,100). Since there is no gain or loss, there is
no tax consequence. Example 1 illustrates the rare occurrence where the conventions
used in the Code to calculate depreciation deductions match the actual decline in the
value of an asset perfectly.
Since the convergence of the “ideal” and “real” world is rare, it is in the other 3
situations that the impact of the depreciation recapture rule for personal property is
demonstrated. Note that the preliminary steps of categorizing the asset and identifying
the potential type of depreciation recapture is presumed in each of the following 3
examples.
EXAMPLE 2: What is the tax result if Kasey sells the riding lawnmower for
$1,000?
Page 7 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
Using the formula for calculating gain or loss found in I.R.C. Sec. 1001, we find
the following:
Amount Realized (AR)
Adjusted Basis (AB)
Gain/(Loss)
$1,000
$1,100
-------(100)
Kasey’s adjusted basis is the same as in Example 1, and equals his cost basis
reduced by the actual depreciation deductions he claimed on the asset. In this
instance, Kasey has realized a $100 loss on the sale. Consequently, there is no
depreciation recapture, since Section 1245 requires recapture of the depreciation
to the extent of the gain. Strictly applying the language of Section 1245, no
recapture occurs, but the lawnmower was a Sec. 1231 asset. Section 1231 states
that losses on the sale of Sec. 1231 assets are treated as ordinary losses, so
Kasey’s $100 loss will be treated as an ordinary loss. The loss will not be
reported as a capital transaction, and will most likely be used to offset other
ordinary income.
Why would Congress be so generous? Perhaps a $100 loss does not make much
of a difference but imagine adding three zeros to that number – the entire $100,000 loss
would have been fully deductible!
In reality, Congress is not being generous at all – it is simply letting Kasey recoup
all of his capital investment tax free. Capital is income that was already subject to tax, so
it should be returned to the owner without assessing an additional tax. Depreciation is
supposed to permit a taxpayer who uses an asset in productive use in a trade or business
or for the production of income to receive his or her capital back, tax free, as the value of
the asset is used up in the activity. In this circumstance, the actual decline in value of the
asset while it was being used in Kasey’s trade or business was:
Cost Basis:
Amount Realized
Decline in Value
$1,500
$1,000
-------$ 500 (This is the “Actual” or Ideal World
Depreciation)
The depreciation that Kasey was allowed to take on the asset, due to the rules set forth in
the Internal Revenue Code, was $400. Therefore, Kasey came up short. If he would
have been allowed a deduction based on the actual decline in the value of the asset, his
depreciation deduction would have equaled $500, but in the real world the make-believe
deduction contrived by the tax code was only $400. If Kasey had taken the full decline in
value as a depreciation deduction, it would have offset ordinary income from his business
operations. Therefore the only fair thing to do in this instance is to allow Kasey to take
Page 8 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
an ordinary loss deduction of $100 for the additional amount of depreciation he
experienced but could not take due to the tax code conventions. This is why Section
1231 treats losses on the sale of Sec. 1231 assets as ordinary losses. If a Section 1231
asset is sold at a loss, the taxpayer did not take enough depreciation over the holding
period of the asset, and, upon sale, the additional depreciation (represented by the loss on
the sale) may be taken as an ordinary deduction so that the ideal and real worlds meet.
After the application of Sec. 1231, Kasey has received all of his capital back tax free:
$400 through depreciation deductions, $1,000 upon sale of the asset, and $100 of Section
1231 loss, which is really a catch-up depreciation deduction. Example 2 can be
summarized as follows:
Ideal World
Real World
Cost Basis
AR
$1,500
$1,000
-------Actual Decline 500
Depr Ded.
$ 500
Sale
$1,000
$1,000 *
--------0
AR
AB
$1,500
$1,000
-------500
$400
AR
AB
Loss
$1,000
$1,100 ($1,500 Cost Basis - $400 Depr)
-------(100) Ordinary Income/Additional Depr
TOTALS After 1231 Treatment:
Depr
$500
$500 ($400 per tax code plus $100 per Sec. 1231)
* The adjusted basis of the asset in the “Ideal World” example is calculated as
follows: Cost Basis $1,500 – Depreciation Deduction $500 = $1,000. Note that
the “Ideal World” in example 2 matches the result in Example 1, above.
Example 2 can be summarized with a simple rule: If a Sec. 1231 asset is sold at a
loss, the resulting loss will ALWAYS be treated as an ordinary loss. Section 1231 allows
this treatment so that the taxpayer can deduct the actual depreciation in the value of the
asset from his or her ordinary business income. If you have identified that a piece of
personal property is a Sec. 1231 asset and is sold at a loss, the loss must be treated as an
ordinary loss.
EXAMPLE 3: What is the tax result if Kasey sells the riding lawnmower for
$1,200?
Page 9 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
Using the formula for calculating gain or loss found in I.R.C. Sec. 1001, we find
the following:
Amount Realized (AR)
Adjusted Basis (AB)
Gain/(Loss)
$1,200
$1,100
-------$ 100
In Example 3, Kasey has a gain on the sale of the lawnmower, which is personal
property and a Sec. 1231 asset. Sec. 1231 states that all gains on the sale of Sec.
1231 assets are capital gains, but before we can get to that we have to consider
depreciation recapture under Sec. 1245. Section 1245 states that depreciation is
recaptured as ordinary income to the extent of the gain. In this example, the
depreciation Kasey took on the lawnmower was $400. His gain on sale was $100.
Since the gain of $100 is less than the depreciation taken, the gain is treated as an
ordinary gain. Kasey would not be able to get capital gains treatment on the gain
until all of the depreciation was paid back.
In Example 1, we saw the rare occurrence of the real world and ideal world
merging. In Example 2, the sale of a personal Sec. 1231 asset resulted in a loss because
not enough depreciation was taken on the asset during the holding period. Example 3
illustrates what happens when too much depreciation is taken on the asset for tax
purposes.
In example 3, the real decline in the value of the asset can be calculated as
follows:
Cost Basis:
Amount Realized
Decline in Value
$1,500
$1,200
-------$ 300 (This is the “Actual” or Ideal World
Depreciation)
Nevertheless, in the make-believe world of depreciation deductions used for income tax
purposes, Kasey claimed $400 in depreciation deductions. Recall that the purpose of the
depreciation recapture rules is to ensure that the appropriate amount of depreciation is
taken at the time that the asset is sold. If too much depreciation was allowed under the
tax code, the “excess depreciation” must be added back to ordinary income so that the
depreciation deduction in the real world equals the depreciation deduction in the ideal
world. Example 3 could be summarized as follows:
Ideal World
Cost Basis
$1,500
Real World
$1,500
Page 10 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
AR
$1,200
-------Actual Decline 300
Depr Ded.
$ 300
Sale
$1,200
$1,200 *
--------0
AR
AB
$1,200
-------300
$400
AR
AB
Gain
$1,200
$1,100 ($1,500 Cost Basis - $400 Depr)
-------100 Ordinary Income/Excess Depr
TOTALS After 1231 Treatment:
Depr
$300
$300 ($400 per tax code minus $100 “recaptured”
or reversed out per Sec. 1231/1245)
* The adjusted basis of the asset in the “Ideal World” example is calculated as
follows: Cost Basis $1,500 – Depreciation Deduction $300 = $1,200. Note that
the “Ideal World” in example 2 matches the result in Example 1, above.
As Example 3 illustrates, when a personal Sec. 1231 asset is sold at a gain, the
gain, to the extent of the depreciation deduction taken, is treated as ordinary income to
offset the excess depreciation taken over the holding period. The excess depreciation in
example 3 is $100 ($400 Depreciation taken - $300 Actual Decline in Value of the asset).
The only way to reflect the actual amount of depreciation on the asset for income tax
purposes is to reverse out $100 of the depreciation deduction by adding it to ordinary
income. Once this is done, a $300 depreciation deduction results, and Kasey recoups the
remaining portion of his capital, $1,200, from the amount realized in the sale.
Example 3 can be summarized by a simple rule: Whenever a personal Section
1231 asset is sold at a gain, compare the gain to the depreciation taken on the asset. If
the gain is equal to or less than the depreciation taken, Section 1245 treats the gain as
ordinary income (and it is sometimes referred to as a Sec. 1245 gain). Section 1245
forces the actual depreciation on the asset to match the depreciation claimed for income
tax purposes by reversing out the excess depreciation taken on the asset.
EXAMPLE 4: What is the income tax result if Kasey sells the riding lawnmower
for $1,700.
Using the formula for calculating gain or loss found in I.R.C. Sec. 1001, we find
the following:
Amount Realized (AR)
Adjusted Basis (AB)
$1,700
$1,100
Page 11 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
Gain/(Loss)
-------$ 600
In Example 4, Kasey has a gain on the sale of the lawnmower, which is personal
property and a Sec. 1231 asset. Sec. 1231 states that all gains on the sale of Sec.
1231 assets are capital gains, but before we can claim that for tax purposes we
have to consider depreciation recapture under Sec. 1245. Section 1245 states that
depreciation is recaptured as ordinary income to the extent of the gain. In this
example, the depreciation Kasey took on the lawnmower was $400. His gain on
sale was $600. Since the gain of $600 is greater than the depreciation taken, the
gain is split into two pieces. Under Sec. 1245, the gain to the extent of
depreciation taken is ordinary income. Kasey took $400 of depreciation on the
lawnmower, so the first $400 of the gain is treated as ordinary income. The
remaining portion of the gain, $200, qualifies for capital gains tax treatment,
because the lawnmower is a Sec. 1231 asset. In this case, since Kasey reversed
out all of the depreciation deductions that he had taken, the remaining gain is
taxed as a capital gain under Section 1231.
In real life, it is rare to come across a situation like that illustrated in Example 4.
Most assets that are purchased for productive use in a trade or business or for production
of income are wasting assets – they tend to wear out as we use them to generate income.
The very fact that they wear out is what justifies the depreciation deduction, which allows
the taxpayer to recoup his capital as the asset is being used up to generate income. In
some instances, this may occur, however. Using the facts of the current case, assume that
the manufacturer of the lawnmower Kasey purchased made such good mowers that they
eventually drove themselves out of business because nobody ever needed to purchase a
replacement mower. Eventually, the company could not sell enough to justify continued
operations, so it closed up. Nevertheless, the reputation of the company’s product
persists, and people in the market for mowers will now pay a premium for one produced
by that company, since they anticipate that it will be the last mower they will have to
purchase in their lifetime. In fact, Kasey was able to sell the mower for more than he
paid for it, despite the fact that he had claimed depreciation deductions. A more common
example is real estate. Depreciation deductions are allowed on the structures purchased,
even though, over time, those structures tend to appreciate in value.
In Example 4, observe that there is no decline in the value of the asset, so in the
ideal world, no depreciation deductions should have been taken. The tax code, however,
allowed Kasey to take depreciation deductions on the mower totaling $400. Since Kasey
took those depreciation deductions against ordinary income, when he sells the mower for
more than the amount he paid for it he will have to reverse out the depreciation deduction
by treating the first $400 of the gain as ordinary income. The remaining portion of the
gain is capital gain, since the mower is a Section 1231 asset. Example 4 can be
summarized as follows:
Page 12 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
Ideal World
Real World
Cost Basis
AR
$1,500
$1,700
-------Actual Decline
0
Depr Ded.
$
Sale
$1,700
$1,500 *
--------200
AR
AB
Gain
$1,500
$1,700
-------0
0
$400
AR
AB
Gain
$1,700
$1,100 ($1,500 Cost Basis - $400 Depr)
-------600 Ordinary Income/Excess Depr
$400
Depr Recap
$200
Capital Gain
TOTALS After 1231 Treatment:
Depr
1231/1245)
$0
$0 ($400 per tax code minus $400 per Sec.
* The adjusted basis of the asset in the “Ideal World” example is calculated as
follows: Cost Basis $1,500 – Depreciation Deduction $ = $1,500. Note that the
“Ideal World” in example 2 matches the result in Example 1, above. The excess
gain, however, would be taxed at capital gains tax rates due to the imposition of
Sec. 1231.
Another way of viewing the application of Sec. 1245 in this case is to compare the
cost basis (purchase price) of the asset to the sale price of the asset. If the sale price
exceed the purchase price, the difference between the sale price and purchase price will
be treated as capital gain, and all of the depreciation will be recaptured as ordinary
income under I.R.C. Sec. 1245.
Example 4 can be summarized by a simple rule: Whenever a personal Section
1231 asset is sold at a gain, compare the gain to the depreciation taken on the asset. If
the gain exceeds the depreciation taken, Section 1245 treats the depreciation taken as
ordinary income (and it is sometimes referred to as a Sec. 1245 gain), and Section 1231
treats the remaining gain as Capital gain. Section 1245 forces the actual depreciation on
the asset to match the depreciation claimed for income tax purposes by reversing out the
excess depreciation taken on the asset, but Sec. 1231 preserves the remaining gain for
capital gains tax treatment.
Page 13 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
The examples above illustrate why asset categorization is important, and should
always be the first step you consider when looking at the taxation of property
transactions. If you characterize the asset as a personal Section 1231 asset (personal asset
used in a trade or business or for the production of income), there are four possible tax
results, three of which are likely to occur in the real world. While the numbers can
change, every transaction resulting from the sale of a Section 1231 asset must fall into
one of these 4 categories. The categories, and decisions rules, are summarized below:
Base Facts
Cost Basis: $1,500
Accumulated Depreciation: $400
AR
AB
Gain/(Loss)
Tax Impact
Scenario 1
$1,100
$1,100
$0
None
Scenario 2
$1,000
$1,100
($100)
Ordinary Loss
Scenario 3
$1,200
$1,100
$100
Ordinary Gain
(Gain is less than
Depreciation taken)
Scenario 4
$1,700
$1,100
$600
Part Ordinary
($400), Part Capital
Gain ($200)
(Gain is more than
depreciation taken)
(The highlighted numbers are used for comparison to determine the tax result.)
Insert summary flowchart – Decision making tree for property transactions/business
assets.
Summary Decision Rules for Planning Under Sections 1231 and 1245
Based on the examples described and summarized above, once you categorize the
asset as a personal, Section 1231 asset, and calculate gain or loss, you know that:
1. If there is no gain or loss, there is no tax impact (you depreciated the property
perfectly).
2. If there is a loss, it is ALWAYS treated as an ordinary loss.
3. If there is a gain,
a. Compare the gain to the depreciation taken on the asset.
b. If the Gain is equal to or less than the depreciation taken, it is treated as an
ordinary gain under Section 1245.
c. If the gain is more than the depreciation taken, the depreciation taken is
recaptured as ordinary income under Section 1245, and the remaining gain
is taxed as a capital gain under Section 1231.
Page 14 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
Recapturing Depreciation taken on Real Estate
If real property used as a Sec. 1231 asset is sold, the recapture rules are a bit
different. I.R.C. Sec. 1250 governs recapture of depreciation on real Section 1231 assets.
Under Sec. 1250 depreciation taken on real estate that exceeds straight line depreciation
is recaptured at ordinary income tax rates.
Under current law, all depreciation on real estate is taken on a straight-line basis.
If the real estate is used for residential purposes, the recovery period is 27 ½ years, and if
the real estate is a commercial property, the recovery period is 39 years. Real estate that
was purchased and placed in service for production of income or business use before
1980 or after 1986 must be depreciated on a straight-line basis. Straight line depreciation
allows the owner to take a constant, monthly allowance for depreciation during the
recovery period. Since Sec. 1250 requires only the depreciation taken in excess of
straight line depreciation to be recaptured at ordinary income rates, real property placed
in service before 1980 or after 1986 will not be affected by Sec. 1250.
Between 1980 and 1986, real estate placed in service for business or production of
income use qualified for accelerated depreciation. Accelerated depreciation allows the
owner of the property to front-load the depreciation deductions so that more of the
depreciation deduction is taken in the early years, and less is taken in later years. When
real property that was depreciated on an accelerated basis is sold, Section 1250 requires
the excess depreciation, calculated by subtracting straight line depreciation from
accelerated depreciation, to be recaptured at ordinary income tax rates.
Section 1250 is quickly becoming a non-issue for income tax planning purposes.
First, only real property that could have been depreciated on an accelerated basis will be
affected by its provisions. Since 1986, real estate does not qualify for accelerated
depreciation. Second, as time goes by, the total depreciation taken on an accelerated
basis approaches the total depreciation taken on a straight line basis, so that at the end of
the recovery period, the total cumulative depreciation deductions taken by the taxpayer
under either system are the same. By 2016, the recovery period for almost all pieces of
real property for which accelerated depreciation could have been claimed will have
expired, at which time the imposition of Section 1250 will not result in additional tax
revenue. It is a rare occurrence where a planner will have to deal with Section 1250.
Nevertheless, if a planner has a client who is planning on selling a piece of real
estate that was used in a trade or business or for the production of income (a Sec. 1231
asset), and that real estate was depreciated on an accelerated basis, the gain to the extent
that accelerated depreciation exceeds straight line depreciation will be recovered at
ordinary income rates.
In 1997, Congress realized that, over time, Section 1250 would become obsolete
and would fail to generate tax revenue. 1997 was also the year that Congress changed the
Page 15 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
capital gains tax rates. Prior to the Taxpayer Relief Act of 1997 (TRA 97), all capital
gains were taxed at 28 percent. TRA 97 lowered the maximum capital gains tax rate to
15% for most assets (5% for those taxpayers in the 15% or lower marginal tax bracket),
but imposed a higher capital gains tax rate in two situations. The first exception to the
15% rate, covered in the chapter on Capital Transactions, imposed a 28% capital gains
tax rate on collectibles. The second exception was a 25% capital gains tax rate on
“unrecaptured Sec. 1250 depreciation.” Apparently, Congress did not want to give up
revenue from depreciation recapture over time, and imposed a new rule that taxes
“unrecaptured Sec. 1250 depreciation” at a flat 25% rate.
Based on our discussion above, it is clear that depreciation in excess of straightline depreciation is recaptured at ordinary income rates, due to the imposition of Sec.
1250. Consequently, the depreciation that is not recaptured under Sec. 1250 (a.k.a.
“unrecaptured Sec. 1250 depreciation”), is straight-line depreciation. As a result of TRA
97, straight line depreciation taken after 1997 on real estate used as a Sec. 1231 asset is
taxed at a flat 25% rate.
To the extent that the gain on the sale of real Sec. 1231 property exceeds the
depreciation taken (both the “excess” portion from accelerated depreciation and the
straight-line portion), the remaining gain is taxed at capital gains tax rates, as set forth in
I.R.C. Sec. 1231.
From a planning standpoint, whenever a real Section 1231 asset is sold, the gain
will be treated as follows for income tax purposes:
1. The lesser of the gain or the difference between depreciation taken and
straight line depreciation will be taxed as ordinary income. (This is
recapture of “excess” depreciation under Section 1250).
2. If the gain exceeds the amount in (1), the lesser of the remaining gain
or the straight line depreciation taken on the property will be taxed at
25% (this is the “unrecaptured section 1250 depreciation”).
3. Any gain in excess of (1) and (2) is taxed at capital gains tax rates (5%
or 15%)
EXAMPLE: Ryan owns a residential apartment building, and has grown weary
of the constant management issues that confront him concerning the property. He
purchased the property for $750,000, and took depreciation deductions of
$400,000. Straight line depreciation on the property would have been $375,000.
If Ryan sells the property for $2,000,000
A. How much of the gain is recaptured under Sec. 1250 at ordinary
income tax rates?
B. How much of the gain will be taxed at 25%
C. How much of the gain will be taxed at normal capital gains tax
rates?
Page 16 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
As a threshold matter, we are dealing with a residential apartment building, which
Ryan used for the production of income. Therefore, the asset is real property used
for production of income, is depreciable, and is therefore classified as a Sec. 1231
asset. Since the property is real estate, the depreciation recapture rules that apply
will be found under Section 1250.
Before we can apply the depreciation recapture rules, however, we must first
calculate the gain or loss generated on the sale. Using the formula for calculating
gain or loss found in I.R.C. Sec. 1001, we find the following:
Amount Realized (AR)
Adjusted Basis (AB)
Gain/(Loss)
$2,000,000
$ 350,000
-------------$1,650,000
Adjusted basis, in this example, equals the cost basis of $750,000 less the
depreciation deductions actually taken of $400,000.
Now that the amount of the gain has been established, we can characterize the
gain for income tax purposes. The first step is to determine if any of the gain will
be taxed at ordinary rates under Sec. 1250. In this case, Ryan took $400,000 of
depreciation deductions, and straight line depreciation would have been $375,000.
Therefore, Ryan took $25,000 in excess depreciation deductions. This amount is
recaptured as ordinary income under Sec. 1250.
$25,000 of the $1,650,000 gain has been characterized, leaving $1,625,000. The
next step is to subject the unrecaptured Section 1250 depreciation to a tax rate of
25%. Ryan took total depreciation deductions of $400,000 and $25,000 of that
amount was recaptured under Sec. 1250. Consequently, the $375,000 of straightline depreciation was not recaptured under Sec. 1250, and will be taxed at 25%.
The remaining portion of the gain, $1,250,000 will be taxed at capital gains tax
rates (in this case, at 15%) due to the imposition of Sec. 1231. These steps can be
summarized as follows:
Gain: $1,650,000
Amount:
$25,000
Treatment:
Ordinary Inc
$375,000
25%
$1,250,000
Capital Gain
Page 17 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
Calc:
(Tot Depr – SL Depr)
SL Depreciation
Excess Gain
Note, as this example illustrates, that the gain is first taxed as ordinary income to
the extent that that Sec. 1250 applies, then the gain is taxed as unrecaptured Sec. 1250
depreciation at a 25% rate. It is only the gain in excess of the depreciation taken that is
taxed at capital gains tax rates. This result is similar to what we observed under section
1245, above – only the gain in excess of depreciation taken will qualify for the special
capital gains tax rate.
EXAMPLE: Ryan sold a residential apartment building that he owned, realizing
a small gain. Ryan took $400,000 in depreciation deductions over the period he
held the real estate, and straight line depreciation would have been $375,000.
1. What is the tax result if Ryan’s total gain is $15,000?
2. What is the tax result if Ryan’s total gain is $200,000?
In the first situation, Ryan’s gain is $15,000. His excess depreciation is $25,000
(Total depreciation of $400,000 less straight line depreciation of $375,000),
which is subject to recapture under Section 1250 at ordinary income tax rates.
Therefore the entire gain is taxed at ordinary rates.
In the second situation, Ryan’s gain is $200,000. As noted above, the first
$25,000 will be recaptured under Sec. 1250 at ordinary income tax rates, and the
remaining $175,000 will be taxed at 25%, since this amount represents
unrecaptured Sec. 1250 depreciation.
In both of these circumstances, none of the gain qualifies for the favorable 15%
capital gains tax rate. That rate can only apply once all of the depreciation is
recaptured under Sec. 1250 or as an “unrecaptured Sec. 1250 gain.”
An alternative way of approaching the taxation of real Section 1231 assets is the
following:
1. The difference between the amount realized and the cost basis equals the capital
gain.
In the original example above, Ryan paid $750,000 for the property and he
sold it for $2,000,000. The difference of $1,250,000 is taxes as a capital
gain under Sec. 1231
2. The depreciation taken on the property is split into two pieces:
a. Straight line depreciation is taxed at 25%
Page 18 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
In the original example above, straight line depreciation would have been
$375,000. This amount will be taxed at 25% as “unrecaptured Section
1250 depreciation.”
b. Depreciation in excess of straight line is taxed at ordinary income tax
rates.
In the original example above, excess depreciation was $25,000 ($400,000
of depreciation taken, less straight line depreciation of $375,000), which
will be taxed at ordinary rates as recapture under Sec. 1250.
The Impact of the taxation of business assets on planning
As we have seen, the depreciation recapture rules for business assets affect the tax
rate that apply to gains on the sale of business assets. In addition, depreciation recapture
must be considered when engaging in various types of tax planning. When assets subject
to recapture are transferred, potential depreciation may be transferred as well.
Depreciation recapture may be an issue with any of the following types of transfers,
which will be discussed briefly below:
1. Gifts
2. Nontaxable Exchanges
3. Transfers at death
4. Charitable contributions
5. Installment sales
When property is gifted, the value of the gift is the fair market value of the property
on the date of the gift, but the basis in the hands of the donee is the donor’s basis,
adjusted for any gift tax paid. Gifts are said to have a “carry-over” basis, since the
donor’s basis is transferred to the donee. The same is true for depreciation recapture. If
the donor held the asset for productive use in a trade or business or for the production of
income, and depreciation was allowed on the asset, any recapture potential will carry
over to the donee. If the gifted asset was personal property, the donee’s gain, to the
extent of the depreciation taken, will be taxed at ordinary income tax rates. If the gifted
asset was real property, the excess depreciation to the extent of the gain will be taxed at
ordinary rates, the straight line depreciation will be taxed at 25%, and any remaining gain
will be taxed at capital gains tax rates. Understanding that depreciation recapture will
carry over may impact the donor’s choice of the appropriate property to give to the
donee.
EXAMPLE: Randy, a local business owner, sometimes converts assets that no
longer have any business use to capital assets (by distributing them from the
business to himself). Randy is in the 25% income tax bracket. He purchased a
desk for use in his business, but upon downsizing the business, converted that
desk to a capital asset. The desk cost $500 and Randy took $250 of depreciation
Page 19 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
deductions on the desk. Randy’s son, Reilly, is in college and needs a desk to
work on his course assignments. Randy transfers the desk to Reilly when the fair
market value of the desk is $260. No gift tax was paid on the transfer. After
Reilly finishes college, he sells the desk to his roommate for $300. What is
Reilly’s gain, and how is it taxed?
Since Randy gifted the desk to Reilly, and the desk had a fair market value in
excess of Randy’s basis ($250 = $500 Cost Basis - $250 in depreciation), Reilly
has a carry-over basis in the desk of $250. Reilly also has a carry-over of the
potential depreciation recapture (requiring the first $250 of gain to be taxed at
ordinary income tax rates). When Reilly sells the desk, the gain can be calculated
as follows:
AR
AB
Gain
$300
$250
-----50
In Reilly’s hands, the desk is a capital asset, which is normally subject to capital
gains tax treatment. Simply looking at this fact might lead one to conclude that
the gain will be taxed as a capital gain. Despite the fact that the asset is a capital
asset in Reilly’s hands, he received the asset as a gift from Randy, who held the
asset, at least for a time, as depreciable personal property used in a trade or
business. The potential recapture, therefore, carried over with the gift. Since
Reilly’s gain is less than the potential recapture amount, the entire gain is taxed at
ordinary income tax rates.
Given these facts, this result could be good or bad. If Reilly does not have
substantial income (he was a college student and was not working full time), he
may be in a low ordinary income tax bracket, perhaps 10%. If Randy sold the
desk for $300 he would have had to pay 25% on the gain (his marginal ordinary
income tax rate), but Reilly would only have to pay 10% on that same gain. From
a family income tax planning perspective, gifting the Desk was a wise strategy,
since it reduced the income taxes that the family, as a group, have to pay to Uncle
Sam. If Reilly was in the 35% ordinary income tax bracket, Randy may want to
consider selling the desk and paying the tax himself, and giving either the
proceeds of the sale, or another asset, to Reilly.
When property is transferred for another property in a non-taxable exchange (such
as a Sec. 1031 like-kind exchange, or a Sec. 1034 involuntary conversion), potential
recapture on the asset carries over to the replacement property.
EXAMPLE: Keegan owns an office building that was destroyed by a Hurricane.
He purchased the office building for $450,000, had taken straight-line
depreciation deductions of $150,000, and the fair market value of the property at
Page 20 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
the time it was destroyed was $800,000. Keegan received a check from his
property insurance carrier for $800,000 and immediately purchased a replacement
office building for $850,000. Keegan’s basis in the original building was
$300,000 (equal to $450,000 Cost basis less $150,000 in depreciation deductions),
and he had potential unrecaptured Sec. 1250 depreciation in the original building
of $150,000. Since Keegan meets the requirements for non-recognition of gain
for an involuntary conversion, his basis in the old building, plus the potential
recapture, will carry over to the new building. In this example, Keegan also put
another $50,000 into the property, which will add to his basis (he paid $850,000
for the new property, but only received $800,000 from the insurance company –
the other $50,000 had to come out of his pocket, so this amount increases his
basis). Therefore, Keegan’s basis in the new property is $350,000; he has
$150,000 of potential unrecaptured Sec. 1250 depreciation that will be taxed at
25% when he disposes of the replacement property in a taxable exchange, and the
fair market value of the replacement property is $850,000.
Exchanging properties in like kind exchanges under I.R.C. Sec. 1031 or in involuntary
conversions under I.R.C. Sec. 1034 does not extinguish the potential depreciation
recapture that applies to the original property.
One way to eliminate potential depreciation recapture, although it is not
something that planners would normally recommend to a client, is to die. Property
transferred through the estate of a decedent receives a step-up in basis under I.R.C. Sec.
1044, and, by receiving the step-up, depreciation recapture is extinguished. This fact can,
in some planning situations, be a valuable one to consider. In the estate planning process,
to the extent that a client will have assets included in his or her gross estate, it may be
wise to hold onto the assets subject to depreciation recapture. Other assets, not subject to
recapture, could be used for gift and inter-vivos transfer planning purposes. Structuring
the estate in this way may minimize the overall tax (income, estate, and gift tax
combined) that is paid by a family on the transfer of their assets. Of course, when
selecting assets to include in the estate, it is not appropriate to look only at the
depreciation recapture potential. An investment consideration that will have a big impact
on that estate planning decision will be the expected growth rate in the asset. To the
extent that the asset will grow substantially in value, it may be better to get it out of the
estate before the growth occurs by gifting the property, even if some depreciation
recapture potential is transferred with the gift. Gifting the property subject to
depreciation recapture potential will remove all of the future growth on the property from
the donor’s estate. This latter planning consideration may be particularly appropriate if
the asset subject to depreciation recapture is real estate.
Potential depreciation recapture may also affect the size of the charitable
deduction a taxpayer may take for gifts of property to qualified charitable organizations.
When a gift of tangible personal property or real estate is made to a charitable
organization that will use that property in their charitable function, the deduction for
Page 21 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
income tax purposes is generally the fair market value of the property on the date of the
gift. When property subject to depreciation recapture is given to a charitable
organization, and the deduction would otherwise be based on the fair market value of the
property, to determine the taxpayer’s deduction for income tax purposes, the potential
depreciation recapture on the asset must be deducted from the fair market value. By
making this adjustment, the government is indirectly recouping the depreciation by
limiting the donor’s income tax deduction.
EXAMPLE: Prior to his retirement, Rennie owned and operated his own
business (a sole proprietorship) for 30 years. He had purchased a building for the
business many years ago for $500,000. Out of the purchase price, $50,000 was
allocated to land and the remaining $450,000 to the building, which was fully
depreciated. When he closed the business, he kept title to the building personally.
An animal rights charity has been looking for a new headquarters, and thinks that
Rennie’s building would be ideal. Rennie has no use for the building, and has
always supported animal rights charities, so he decides to give the building to the
charity. The value of the building at the time of the transfer is $1,500,000.
Normally, Rennie would receive a $1,500,000 charitable deduction for such a
transfer, but this building has potential depreciation recapture attached to it, so the
charitable deduction is reduced by the amount of the recapture. Rennie can take a
charitable deduction of $1,050,000 for the gift he made to the animal rights
charity.
Another planning device that can be affected by potential depreciation recapture
on property is the installment sale (including, for our discussion here, regular installment
sales, self-cancelling installment notes (SCINs), and Private Annuities). When an asset is
transferred, gain is usually realized and recognized. Recognition of gain on the sale of an
asset in return for an installment note can typically be deferred under the installment
reporting provisions of the code. If an asset is sold today, but equal principal payments
plus interest will be made over a ten year period, the seller can elect to report 10% (1/10th
)of the gain he realized this year in each of the next ten years instead paying tax on all of
the gain in the year that realization occurs. Installment reporting is helpful from a
planning standpoint, since it allows the taxpayer to smooth his or her income, report less
of a gain in each year during the installment period (possibly staying in a lower tax
bracket), and defer tax. The installment reporting provisions, however, do not apply to
potential ordinary income depreciation recapture on Sec. 1231 property sold in return for
an installment note. The ordinary income depreciation recapture, to the extent of the
gain, must be recognized in the year the gain is realized. The unrecaptured Sec. 1250
depreciation may be deferred under the installment reporting provisions, but all of the
gain in each installment reporting year will be taxed at the 25% unrecaptured Sec. 1250
rate until all of the straight line depreciation has been recaptured. Once the portion of the
gain representing unrecaptured Sec. 1250 depreciation has been fully reported, any
remaining gain will be taxed at 15% or 5%.
Page 22 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
EXAMPLE: After 20 years of managing his rental apartment building, John
decides it is time to retire from the landlord business – he no longer enjoys the
hastles of management. He purchased the Apartment building for $1,500,000 and
$100,000 of the purchase price was allocated to land. Total depreciation taken on
the building was $1,000,000 and straight line depreciation would have been
$800,000. The apartment complex is now worth $8,100,000. John has agreed to
sell the apartment complex to a young business associate, Ryan, for it’s current
fair market value to be paid in an installment note over 20 years. The note carries
an interest rate that matches the IRS published rate necessary to avoid gift-loan
status. While John will be able to defer some of his gain over the 20 year period,
the potential ordinary income depreciation recapture cannot be deferred. In this
case, the potential ordinary income recapture is $200,000 ($1,000,000 in total
deprecation less straight line depreciation of $800,000). Despite the presence of
the installment sale, John will be required to pay ordinary income tax on
$200,000 in the year of sale. As John receives payments over the first several
years, the gain portion of each payment will be treated as the unrecaptured Sec.
1250 gain and will be taxed at 25% until the tax on the unrecaptured Sec. 1250
gain has been paid in full. Any remaining gain will be taxed at the 15% (or 5%, if
applicable) rate.
Observe that this could create a cashflow problem for John. If Ryan only pays
1/20th of the purchase price plus interest to John this year, but John has to pay up
to 35% on $200,000 in the year of sale, plus tax on the interest and a 25% tax on
part of the unrecaptured Sec. 1250 gain received in this year’s installment
payment John may not have enough money to meet the tax obligation. This could
be an important consideration when recommending the structure of an installment
sale to a client. For example, if a cashflow problem would occur, Ryan could
make a down payment equal to (at a minimum) the tax that will be due as a result
of the recapture. This would ensure that John does not have to dip into his other
assets simply to pay the tax on the sale.
As these examples illustrate, depreciation recapture is important in ways other
than simply determining which tax rate applies. In many cases, the presence of potential
depreciation recapture may change the planning options that the client faces.
Understanding why this happens and what situations to watch out for allow planners to
give better, more competent advice to their clients.
The 5-year lookback rule
The astute planner, having learned how the depreciation recapture rules work,
might have spotted a potential planning opportunity. Similar to the netting process for
capital gains, all 1231 gains for the year are added together, and all 1231 losses for the
year are added together, and losses are offset against gains to determine the net 1231 gain
or loss. Since gains are treated as capital gains (subject, at least for individuals, to a lower
Page 23 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..
tax rate) and losses are treated as ordinary losses, it would be beneficial, from a tax
planning standpoint, to generate 1231 losses in one year, and 1231 gains in another year.
By separating gains and losses, all of the gains would be taxed at the lower capital gains
tax rate in one year, and all of the losses will generate a tax benefit at a higher ordinary
tax rate in another year instead of offsetting each other.
Unfortunately, Congress thought of this planning option as well. To help combat
this form of planning, there is a 5-year lookback rule that applies for Sec. 1231. The
lookback rule states that a net Sec. 1231 gain in the current tax year (which should be
taxed at capital gains tax rates) will be taxed at ordinary income tax rates to the extent of
any Sec. 1231 losses claimed during the last 5 years. The lookback rule forces the netting
process to occur over a 5 year period. Note that for the lookback rule to apply, (1) there
must be a net Sec. 1231 gain in the current year, and (2) there must have been Sec. 1231
losses in the last 5 years. If there is a net Sec. 1231 loss in the current year, or if there are
no Sec. 1231 losses in the last five tax years, the lookback rule does not apply.
Special Rules
Corporations
Related Parties
Intangible Drilling Costs
Page 24 of 24.
Copyright © 2007. Thomas P. Langdon. All rights Reserved. This is a draft of a chapter to be published in a forthcoming book, and
may not be reproduced or used without the express written permission of the author. A non-exclusive license to use these materials is
granted to students in the Georgetown and Fordham CFP Income Tax Classes held in the first half of 2007 solely for the purpose of
completing the Federal Income Tax Class and preparing for the National CFP examination..